Personal Guarantors Judgment – Time For Promoters To Right-Size Insolvency Risk

A danger sign warning of an unstable cliff stands on the cliff edge on the North Norfolk coast in the U.K. (Photographer: Chris Ratcliffe/Bloomberg)

Personal Guarantors Judgment – Time For Promoters To Right-Size Insolvency Risk

BloombergQuintOpinion

cThe Insolvency and Bankruptcy Code, 2016 has emerged as the most impactful legislation for enforcement actions by creditors against corporate debtors. Its interpretation has not been without controversy – for that you may thank the ingenuity of various stakeholders or lay blame on legal acumen of draftspersons. The phased rollout of the code, timely legislative actions and swift judicial interventions are examples of credible implementation of a statute of such gravity. Amendments to the code have been frequent, a phenomenon seldom witnessed in other statutory fiscal legislation. That underscores its importance.

The Code - A Change Agent For A New Financial Culture

Over five years, the Supreme Court has provided priority and clarity to matters under the code.

In the Innoventive Industries case, it was held that the code is a complete legislation for bankruptcy matters.

After that in the Swiss Ribbons case it was held that wisdom of committee of creditors is supreme in commercial matters.

Subsequently, in the Essar Steel case, priority of secured creditors and clean slate status of corporate debtor after approval of resolution plan was upheld.

Thus the law read by the Supreme Court has added to the reliability quotient of the code, the latest being a judgment that upheld the validity of a November 2019 government notification which enabled proceedings against personal guarantors of a corporate debtor.

In the Lalit Kumar Jain case, given its urgency and wide ranging impact, the Supreme Court exercised its plenary jurisdiction and transferred to itself all high court cases dealing with personal guarantees of a corporate debtor, thereby preventing inconsistent principles that could have arisen and frustrated the resolution process.

This most recent case is of importance for a host of reasons.

Also read: Supreme Court IBC Ruling Good For Companies, Bad For Guarantors

Challenge And Key Outcomes

The challenge was to invalidate a notification issued by the union government permitting insolvency proceedings against individuals who are personal guarantors of a corporate debtor. This was done by enabling one set of provisions relating to personal insolvencies in the Code. The other sets, pertaining to individuals, partnership and proprietorship firms, remain inoperative as they are yet to be notified.

The most emphatic contention against the notification, by petitioners including several business promoters, was that the government has no authority – legislative or statutory – to impose conditions on the enforcement of the code. It was argued that the law does not permit the government to notify parts of provisions of the code, and part notification by government amounts to a legislative action (because it usurps the power of the legislature) and, is therefore illegal.

The court taking cognizance of the method adopted by government, of bringing into force different provisions of the code in a phased manner, opined that the same fulfills objectives underlying the code regarding its priorities. It concluded that the notification under challenge is not an instance of government exercising impermissible acts.

Enabling Group Insolvency

The court observed that all matters that are likely to impact or have a bearing on a corporate debtor’s insolvency process are to be clubbed before the same forum.

The observation is an enabler towards group insolvency actions.

Such group insolvency can occur when multiple entities or debtors are clubbed for insolvency resolution and have common promoters, and if assets are combined resolution will be more fruitful from commercial standpoint.

Also read: NCLT To Use Videocon Case As Precedent For Group Insolvency Cases

Cross-Border Debt Recovery

The judgment reaffirms that the code always contemplated overseas assets of a corporate debtor or its personal guarantor to be dealt in the same fashion, including by issuing letters of request to courts or authorities in offshore jurisdictions. This is a step towards possible cross-border actions.

Proceedings against overseas debtors or personal guarantors have rarely been invoked in debt recovery or resolution proceedings in India. We have seen criminal proceedings being initiated by the Enforcement Directorate or the Central Bureau of Investigation.

This judgment paves the way for proceedings in overseas jurisdictions against errant promoters who may have turned fugitives. The UNCITRAL Model Law on Cross Border Insolvency will be a guide for such action after adoption of the same by India.

Guarantor Liability Open-Ended

The judgment also clarified that the sanction of a resolution plan and finality imparted on account of closure of corporate insolvency resolution process does not per-se discharge a guarantor’s liability.

That opens avenues for enforcement actions against personal guarantors in many resolved cases.

In short, creditors may initiate insolvency proceedings on personal guarantors before proceeding against a corporate debtor or during a corporate insolvency resolution process or liquidation, or after approval of a resolution plan. There is also potential for insolvency actions against personal guarantors in many cases where resolution plans are approved.

What Next For Promoters?

It is a general trend in Indian banking that promoters are asked to execute guarantees for loans taken by companies controlled by them. An interest rate benefit is rarely given due to such a guarantee which means there is no change from a credit risk standpoint for a lender. Even then, the practice of promoter guarantee got engraved in lending dynamics probably as a control mechanism to prevent preferential and fraudulent transactions.

With the advent of the code, there is now an enforceable method for controlling the same risk.

The law being more stable, creditors will see promoters negotiating their guarantees to right-size their financial risk.

While executing new guarantees, promoters will hereon ring-fence their interests appropriately. Further, corporate debtors will exercise greater diligence to prevent enforcement actions under the code.

Side Effects

We are yet to experience implications of insolvency proceedings against personal guarantors with multiple businesses. The proceedings against one business may adversely affect their other businesses or interests in other businesses/assets.

The objective of the code being revival, promotion of entrepreneurship and availability of credit etc, related businesses should ideally not be victims of unintended consequence.

Promoters will need to think hard about group structures and issuance of guarantees and cross-guarantees to group companies, a common phenomenon among entrepreneurs with multiple interests.

It would be unjust if the failure of one business would bring to risk all other business assets of promoters, unless the insolvency is on account of fraud or foul play.

Policy Guidance

While the resolution of a failed business is critical, the sustenance of a successful promoter is equally important for promoting entrepreneurship in India.

Perhaps, policy guidance supporting promoters during insolvency resolution and preventing failure of their other businesses as a consequence is the need of the hour.

It will be good to have a support mechanism for other functional businesses of a personal guarantor facing insolvency, such as a panel of financial creditors as revival agents.

It is important to lay down a procedure to contribute to what the IBC stands for in true spirit.

Mukesh Butani is Managing Partner, Pradeep Joy is Of Counsel, at BMR Legal. The authors were involved in this case on behalf of a bank subsidiary.

The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.

BQ Install

Bloomberg Quint

Add BloombergQuint App to Home screen.